Principles of Investment Risk - 1 Flashcards
Simple Compound Interest Formula?
FV = PV ( 1 + r )^n
Discrete Interval Compound Interest Formula?
FV = PV ( 1 + r/ j)^nj (where j = frequency
Continuous Compound Interest Formula?
FV = PV * e^RT
Present Value Formula?
PV = FV / ( 1 + r )^n
PV of an annuity?
PV of an annuit y = P × (1- (1 + r ) -n /r)
PV of an Perpetuity?
PV of a perpetuity = Amount of periodic payment / r
Perpetual Bond Calculation?
Price = annual coupon rate / gross redemption yield
Preference share Calculation?
Price = Dividend / Holder’s expected return
What is the formula for the future value of frequent idientical payments (if payment at start of year)?
Compound Interest to Regular Payments Calculation (if payment at end of year)?
Basic Inflation Calculation?
Nominal return − Rate of inflation = Real return
Accurate Inflation Calculation?
(1 + Real rate of return ) × ( 1 + Inflation rate ) = 1 + Nominal rate of return
What is the difference between Systemic risk & Systematic risk
- Systemic Risk = financial system instability, potentially catastrophic, caused or exacerbated by idiosyncratic events or conditions in financial intermediaries
- Systematic risk is one which affects the financial system as a whole e.g. inflation or interest rates
What is Unsystematic Risk?
Those which relate to a particular business, investment or share so they can usually be reduced through diversification
What is the relationship between variance and standard deviation?
Standard deviation is a square root of the variance of the dispersion
What is the coefficient of variation and its uses?
- Coefficient of variation ( CV ) = σ (sd) / µ (mean)
- The CV is a measure of the amount of risk taken with each investment for a 1% unit of return, thus allowing us to make comparisons between two investments
What level of correlatiom maximises diversification?
- Diversification benefit is maximised by holding investments exhibiting low (ie, close to zero) correlation
Holding Period Return (HPR) formula?
HPR = (Sum of all income + Ending Valuation - Starting Valuation) / Starting Valuation
Money Weighted Rate of Return (MWRR) formula?
MWRR = (Sum of all income + Ending Valuation - Starting Valuation +/- New money during the year) / Starting Valuation + ∑ (new money * n/12)
Also known as IRR
Time Weighted Rate of Return (TWRR) formula?
TWRR = (1 + R1)(1 + R2)…..(1 + RN) − 1
Where R i is the simple return in each sub-period, calculated as:
Ri = (V1 − V0) / V0
Sharpe Ratio formula?
Sharpe ratio = (Portfolio Return - Risk Free Return) / σ
What is the Sortino Ratio and its formula?
Same as sharpe ratio but only measures downside risk
Sortino ratio = (Portfolio Return - Required rate of Return) / σ of returns below threshold
ANY RATE OF RETURN BELOW THE REQUIRED RATE IS INCLUDED IN THE CALCULATION
What is the Treynor Ratio and what does it measure?
Treynor ratio = (Portfolio Return - Required rate of Return) / β Beta
the higher the ratio, the greater the excess return that is being generated by the portfolio for each unit of overall market risk
What is the Jensen’s Alpha and what does it measure?
- Calcultates the excess return on a portfolio vs the theoretical return of that portfolio according to CAPM:
- Alpha = Portfolio Return - Rcapm
Where Rcapm = Risk Free rate + β(Market rate of return - Risk Free Rate)
- This does NOT show manager skill, just the portfolio outperformance not explained by CAPM
What is the Information Ratio and what does it measure?
- It compares the excess return achieved by a portfolio over a benchmark to the portfolio’s tracking error, which is calculated as the standard deviation of excess returns from the benchmark.
IR = the arithmetic mean of excess returns / benchmark σ
What is R^2 and what does it measure?
- R-squared is used to denote the extent of diversification within a portfolio relative to a benchmark.
- The closer that the R-squared is to zero (ie, 0%), the greater the indication that its returns are not attributable to the performance of the benchmark index
Holding Period Return of a Two-Security Portfolio
Overall Return = (% allocation of A * Return on A ) + (% allocation of B * Return on B )
How many securities are needed to provide good diversification?
A portfolio that is equally weighted in 15 to 20 securities should diversify specific risk
What is the synthetic risk and reward indicator (SRRI)? (used for UCITS funds)
- An overall measure of the risk (and reward) of a fund, ranging from 1 to 7, determined from volatility of past returns (as measured by the fund’s NAV) over a five-year period.
- The lower the score, the lower the risk (and, therefore, typically the reward) of the investment, while a higher score corresponds to a high-risk (and typically higher-reward) investment.
What is the summary risk indicator (SRI)? (used for PRIIPS)
- A combination of two components: a market risk measure (MRM), which determines
1) the investment’s market risk on a scale of 1 (low risk) to 7 (high risk); and
2) a credit risk measure (CRM), which assesses credit risk within a range of 1 (low risk) to 6 (high risk)
What is the Risk Premium on an investment?
The additional return it generates above the risk-free rate
Which investment theory focuses on standard deviation?
EMH, MPT or CAPM
MPT
Given two investments with the same return, the one with the lower standard deviation would be regarded as the lower risk.
Which investment theory focuses on diversification?
EMH, MPT or CAPM
MPT
The key way to reduce the risk of the portfolio is to diversify the portfolio
When is the efficiency frontier curve it its steepest vs its flattest?
The lower the risk, the steeper the curve
As risk increases, the curve flattens
Which investment theory focuses on beta?
EMH, MOT or CAPM
CAPM
It argues that the most important measure of risk is the sensitivity of the security to the market as a whole this sensitivity being measured by the ‘BETA’ of the security.
